Lecture 1: Course Overview and Review of Institutions and Markets

The goals of this class


  1. Understand important financial institutions and markets
  2. Provide a toolkit for creating portfolios of financial assets
  3. Use asset pricing models to understand the trade-off between risk and return
  4. Apply these models to:
    1. identify investment opportunities
    2. evaluate portfolio performance

Who am I?


  • Former research economist at the Federal Reserve Bank of New York (2015-2018)
  • PhD in economics at Harvard from 2009-2015
  • Research associate at the FRBNY (2007-2009)
  • Main research focus:
    1. Consumer finance – bankruptcy, mortgages, housing
    2. Applied statistics – machine learning and other methods
  • Email:
    • Please reach out if you have any concerns or questions re: policy that are not laid out in the syllabus.
  • Website: http://paulgp.github.io
  • Office: 4532

Timeline for our course

Part 1: Institutional details

  • Who are the buyers and issuers of financial instruments?
  • Define assets + securities classes
  • How are financial assets traded?
  • How have these financial assets performed historically?
    • Strong focus on statistical properties and data

Timeline for our course

Part 2: Portfolio tools

  • How do we interpret observed returns?
    • Build to a model of returns
  • Three ingredients necessary for our models:
    1. Defining risk appetite/aversion
    2. Understanding mean‐variance trade-off
    3. Allocating between risky and safe investments
  • Use models to construct a portfolio of risky investments
    • Captial Asset Pricing Model
    • Arbitrage Pricing Theory / Factor Models

Timeline for our course

Part 3: Critical evaluation of the tools

  • How consistent is CAPM with the data?
  • How consistent is the data with APT?
    • Markets are efficient? Or is it behavioral?
  • How should we use the models when there are market anomalies?
    • Active portfolio management
    • Treynor-Black / Black-Litterman
    • Robust Portfolio Management

Timeline for our course

Part 4: Evaluate and attribute portfolio returns

  • CAPM / APT describe returns from a passive strategy (no skill required)
  • How should we evaluate active managers?
    • Portfolio evaluation techniques answers:

      “Did you beat your benchmark?”

    • Performance attribution answers the question,

      “How did you beat your benchmark?”

Timeline for our course

Part 5: Applications and alternative forms of investing

  • Private equity and hedge funds
  • International investing
  • Fixed income (bonds, futures, forwards)

Class requirements

  • Straight from the syllabus!
  • Three problem sets as homework:
    • Due February 16, March 2 and May 4
    • To be done individually
  • Two case write-ups:
    • Yale University Investments Office (Due in class April 4)
    • Firefighter (Due in class April 18)
    • To be done in groups 3-5
  • One midterm and one final:
    • March 5 in class
    • May 7 in class

Section 1 TA: Nikhil Maddirala

Section 2 TA: Akshay Rao

Institutions

Global assets under management

Institutions

U.S. Institutional Holdings

Institutions

Mutual Funds

  • Also known as open-end funds
    • Investors pool and benefits from sharing information
      collection and back‐office costs
  • Fund issues new shares when investors buy in and redeems shares when investors cash out
  • Priced at Net Asset Value (NAV):


\[ \frac{\text{Market Value of Assets} - \text{Liabilities}}{\text{Shares Outstanding}} \]

Institutions

Mutual Funds Fees

  • Fee Structure: Four types
    1. Operating expenses (recurring)
    2. 12 b‐1 charge (recurring)
    3. Front‐end load (one time)
    4. Back‐end load (one time)
  • Fees must be disclosed in the prospectus
  • Share classes with different fee combinations

Institutions

Example of Fees for Various Classes of Mutual Funds

  • Compare the A, B and C shares
  • What are the trade-offs between initial and deferred loads?
  • Level of annual fees and expenses

Mutual Funds - Fees and Incentives

  • People don’t avoid high-fee index funds (Choi et al. 2010)

  • Experimenters overfocused on returns since fund inception

Mutual Funds - Fees and Incentives

Fund flow response distorts risk-taking incentives (Chevalier and Ellison (1997))

Mutual Funds - Costs over time

Mutual fund expense ratios have fallen over time, driven by several factors

  1. Scale economies - assets under management have grown
  2. Competition - investors pick funds with lower expense ratios
  3. Increased presence of employer-sponsored retirement plans

Source: Investment Company Institute

Do mutual fund managers earn their fees?

  • How could we answer this?
  • One idea: how do mutual funds do compared to an index?
  • Performance of actively managed funds below the return on:
    • the Wilshire index in 23 of the 39 years from 1971 to 2009
    • the S&P index in 30 of the 47 years from 1970 to 2017

Institutions

Mutual Funds - Do fund managers earn their fees?

  • Are all mutual fund managers like Andy Dwyer, or just the average?
  • Malkiel (1995) evaluates 239 mutual funds with at least ten-year records
    • Compare each fund’s performance to holding the S&P 500

Institutions

Mutual Funds – is there a “hot hand”?

  • Evidence for persistent performance is weak, but suggestive
  • Malkiel (1995) tracks funds based on above/below median performance:

Institutions

Mutual Funds – Persistence in performance?

  • Bollen and Busse (2004) find tiny persistence at the quarterly level

Institutions

Mutual Funds – luck or skill?

Fama French “Luck vs Skill in Mutual Fund Returns” 2010

  • Value weighted portfolio of active funds earns the market return, minus fees
  • Distribution of “alpha” looks more consistent with luck than skill

Net Returns

Gross Returns

Institutions

Closed End Funds

  • Unlike mutual funds (open-end), no change in shares outstanding
  • Old investors cash out by selling to new investors
  • Managers unburdened with managing flows
  • Traded continuously on exchanges
  • Priced at premium or discount to NAV
    • No easy arbitrage to close price gaps
  • Hedge funds may ride discounts
    • Alternatively, may attempt to “open” funds

Institutions

What else? Other buyers/Other perspectives

  • Pension funds
  • Endowment Funds
  • Alternative Asset Managers
    • to be discussed in the context of cases and guest lectures
  • Next up…market structure

Market Structure

What kinds of markets are there?

  1. Specialist Markets
  2. Over-the-counter (OTC) markets
  3. Electronic Communication Markets

Market Structure

What types of orders are there?

  • Market order – Buy or sell order to be executed immediately at prevailing bid/ask price
  • Limit order – Buy or sell order with a pre‐specified limit for the price

Limit orders make up a limit order book

Limit orders make up a limit order book

Market Structure

Types of Markets: Specialist Exchanges

  • Example of a specialist exchange: NYSE
  • Trading traditionally occurred through a combination of an auction (the order book) and a market maker (the specialist)
  • Orders sent to exchange may be cleared electronically or sent to specialist
    • Only one specialist for each stock
    • Specialist may act as broker or as a dealer

Market Structure

Roles of Specialists in Specialist Exchanges

  • Broker
    • Matches buy and sell orders
    • Income generated by commissions
  • Dealer
    • Specialists maintain their own bid and ask quotes and fill orders with own account if market spread too high
    • Historically, participated in about 25% of all transactions
    • Maintained price continuity

Market Structure

Types of Markets: OTC Markets

  • Trades negotiated dealer‐to‐dealer
  • Nasdaq (National Association of Securities Dealers Automated Quotation system)
    • Originally, a price quotation system
    • Large orders may still be negotiated through brokers and dealers
    • Today, NASDAQ provides electronic trading (less OTC)

Market Structure

Types of Markets: Electronic Communication Networks

  • Private computer networks that directly link buyers with sellers for automated order execution
  • To attract liquidity, networks may pay rebates to liquidity providers (market makers)
  • Electronic clearing facilitates high frequency trading

Market Structure

Electronic Communication Networks and High Frequency Trading

  • Risks of high speed algorithmic trading include market disruption
  • Flash Crash (2010)
    • On May 6, 2010, US indices fell by more than 5% in a matter of minutes, before rebounding almost as quickly
  • Knight Capital (2012)
    • Flawed deployment of new trading program bankrupts major market maker
    • Lost 440 million dollars from one programming mistake

Market Structure

Electronic Communication Networks and flash crashes

SEC findings suggest the decline was triggered by a large automated sell order for S&P futures by a mutual fund

  • Existing low volume due to high market uncertainty
  • Sell order (75K contracts) was an automated algorithm that directed to sell 9% of prior minute’s trading volume
  • HFTs responded to high volume of trades, but could not find fundamental buyers (SEC describes a game of “hot‐ potato”)
  • High volume led to acceleration in sell order speed, which drove higher volatility and volume

Market Structure

Short-selling

  • In our optimal portfolio, we’ll have the option to “short”–sell stocks that we don’t own
  • Why would we?
    1. Stock may be overpriced (negative alpha)
    2. Stock may be appropriately priced, but we want to hedge out risk from a long position in a similar security (pairs trading)
  • So what is it?

Short-selling: you have to fight the witch

(Not really)

Market Structure

Short-selling Mechanics

Suppose we have one dollar and believe stock A will underperform stock B.

  • Buy $1 of stock B
  • Borrow $1 worth of stock A ( \(1 \big/ P_A\) shares) and promptly sell the stock
    • Now, you owe the owner of A his shares back and will have to repurchase them in the market at tomorrow’s price
    • Proceeds from the sale serve as collateral to stock lender (e.g. $1)
    • Reg T requires 50% additional collateral (above and beyond proceeds) be kept in account (shares of B will suffice)


\[\text{Final Payoff} = 1 + (r_B ‐ r_A) + \ldots+ \underbrace{\text{short rebate}}_{\text{to be defined}}\]

What happens if stock goes down 10x? up 10x?

Market Structure

What is the short rebate?

  • Short rebate is the interest I earn on my dollar of collateral sitting with the stock lender

\[ \text{Short Rebate} = r_{f} - \text{Security lending Fee} \]

  • Securities lending fees vary greatly and reflect how easy the shares are to borrow (often less than 20 bps)
  • In obvious shorting situations, short rebate will go negative (shares “hot or trading “special”) or can’t be found

Market Structure

Alternative ways to short stocks: synthetic shorts

Consider the following replicating strategy:

  • Buy a put and sell a call at the current strike price
    • Have the option to sell stock at current price
    • Give someone else the option to buy the stock at today’s price
  • What happens if real stock goes down 10x? up 10x?
  • However, options traded on less than half of publicly traded firms
  • Moreover, options market behaves badly for “hot shares”
    • Put-call parity is violated by large amounts of short interest – E.g. 3com and Palm

Market Structure

Can the Market Add and Subtract? 3com/Palm Example